Canadian titans Loblaw, Shoppers Drug Mart set to merge

SDM shares immediately rose 24%, close to the value of the offer. Unusually for the stock of an acquiring company, Loblaws’ shares also showed upside, gaining 5.4%.

Under the terms of the agreement, Loblaws will acquire all the outstanding shares in SDM for $33.18 in cash plus 0.5965 of one Loblaws common share per SDM common share. The offer represents a 29.4% premium over SDM’s closing price on the preceding Friday.
Shoppers Drug Mart is to continue to operate as a distinct entity with its own dedicated management.

The merged organization will dwarf the size of its competitors in the Canadian market. On a pro forma basis, the combined company in 2012 would have generated in excess of $42 billion in revenue, $3 billion in EBITDA (earnings before interest, taxes, depreciation and amortization) and $1 billion in free cash flow. The transaction is expected to lead to double-digit accretion, adjusted for intangible amortization, in Lob­laws’ earnings per share, in the first year.

In 2012 Loblaws had sales of $31 billion and EBITDA of $1.97 billion, and currently has 1,027 stores occupying 51.5 million square feet. It has 134,000 employees. SDM last year had sales of $10.8 billion and EBITDA of $1.19 billion, and currently has 1,295 stores, occupying 13.7 million square feet. It has 51,300 employees.

The proposed deal will require approval by SDM’s shareholders and will be scrutinized by Canada’s Competition Bureau. It is not expected that there will be competition issues of any consequence involving ­divestitures.

Food products represent only about $1 billion of SDM’s volume, and though Loblaws has been working hard at expanding its pharmacy volume, it still accounts for just around 5% of national pharmacy business. Between them, the two operations are expected to account for some 125 million prescriptions a year.

The companies apparently have held on-and-off discussions about a merger for about three and a half years, SDM chairman Holger Kluge disclosed at a news conference following the announcement.

“In the end it just happened to be the right time when these two minds came together, and came together quickly, but we believe at the right price for our shareholders,” he said.

Kluge indicated that SDM had been in communication with other prospective acquirers, some discussions apparently initiated by SDM, others on a responsive basis. It is assumed that some of the interested parties were from the United States.

SDM has undertaken not to solicit competing bids. It is possible, however, that some of the other interested parties will now attempt a counter bid. In this circumstance the agreement provides for a $300 million break fee to be payable to Lob­laws and the opportunity for Loblaws to match the competing bid.

Impediments to an earlier bid by Loblaws were likely attributable to a difficult financing climate and the disparity in values the market assigned to the two companies’ shares. Loblaws, in the current easier market conditions, was able to secure financing supplemental to its own cash resources from Merrill Lynch, Pierce, Fenner & Smith Inc. and Bank of America.

A year ago Loblaws stock was trading at around $32 against $48 in the week preceding the offer. The stock had been boosted by the company’s recent action to spin off much of its valuable real estate to a real estate investment trust.

In contrast, SDM’s stock, which had been trading in the high $50s five years ago was trading in the $40 range, largely as a result of the decisions of provincial governments to rein in the permissible prices of generic drugs, significantly affecting the profitability of the dispensing function.

Loblaws management has also, over the last seven years or so, been much preoccupied with its “transformation” of the company, after its radical and, as it proved, ill-advised attempt to make a big push into general merchandise in anticipation of the introduction of Walmart’s Supercenters to Canada. That long and costly overhaul, including the reworking of the IT system, is now close to completion, allowing management to think more expansively.

Along with the recent show of confluence in the value of Loblaws’ and SDM’s stock, other recent changes to the Canadian retailing landscape likely prompted Loblaws to pull the trigger on the SDM deal.

The purchase of Canada Safeway’s stores by Empire Co., the parent of Canada’s second-largest supermarket chain, Sobeys, reduced the opportunities for acquisitions that could deliver significant synergies.

Some analysts have been speculating that Loblaws must have felt it had to act before all major acquisition targets disappeared. Certainly, the announcement of the Loblaws/SDM deal had a positive effect on the price of the shares of other Canadian retail public companies. At the end of the day when the news broke, Jean Coutu Group’s share price increased by 3%, convenience store operator Couche-Tard’s rose by 1.5% and Metro’s gained by 2.2%.

The management of Metro, Canada’s third-largest supermarket chain, whose operations are confined to the Quebec and Ontario markets, has indicated interest in expansion by acquisition if the right opportunity, at the right price, presents itself.

With the Canada Safeway and SDM deals done, its options are shrinking. The two remaining major supermarket chains seen as possible targets, Overwaitea and H.Y. Louie Co. (operating IGA stores in British Columbia and London Drugs in the four western provinces), are both privately controlled and neither has exhibited any enthusiasm for making a sale.

Jean Coutu, particularly after embarking on the construction of a new and enlarged distribution facility, has positioned itself more as a potential acquisitor than a seller.

What remains are some relatively large independent grocers and several large and midsize corporate and franchised pharmacy chains such as Katz Group and Uniprix. Yet none of these companies seem eager to dispose of their profitable assets.

Whatever other consolidations take place, there is likely to be no letup on competitive pressures in the sector. New square footage is coming on the market at a steady pace. Target Corp. is expected to have 124 Canadian stores open by November. Walmart is adding up to 800,000 square feet a year, and Sobeys can be expected to vigorously pursue its program of opening the small urban units with which it has been having ­success.